Partnership allocations may be tested with a more jaundiced eye by the IRS, the agency warned.
Partners in corporate joint ventures or partnerships are given a fairly free hand by the US tax authorities in how they share cash, taxable income and other benefits from the partnership. In general, partners can do what they want as long as they maintain “capital accounts” — or a record of what each partner contributed to the venture and what each got out. If a partner has a negative capital account, then that usually means the partner took out more than his or her fair share. IRS rules require that the partner either indicate a willingness to pay back money into the partnership when the venture liquidates to eliminate the capital account deficit, or else the partnership must take steps during the life of the partnership to prevent partners from having negative capital accounts — for example, by reallocating amounts that would throw a particular partner into deficit to the other partners.
Tax lawyers call this ensuring that the business deal has “economic effect.” The IRS makes it a condition to letting partners do what they want that their business deal must have “economic effect.”
The IRS requires the economic effect must also be “substantial.”
The agency has various ways of testing whether the economic effect is “substantial.” One is to probe whether a particular allocation makes at least one partner better off after his or her tax position is taken into account while no one else suffers. The calculations are done using present values. Some companies have taken the position that they only have to look at the after-tax consequences at the level of the partners and not look higher up the ownership chain.
The IRS made clear in November that it disagrees.
It said in proposed regulations that the tax consequences to a partner that joins in filing a consolidated return with other corporations must be weighed by looking at the effect on the consolidated group. Thus, for example, if a corporate partner is allocated depreciation deductions that it cannot use as a standalone company, but that will be absorbed immediately on the consolidated return that it joins in filing, then the immediate benefit must be taken into account in assessing whether only the government loses from an allocation. If the partner is itself a partnership, then one should look higher up the ownership chain. If the partner is a foreign corporation that is owned more than 50% by US shareholders — a so-called “controlled foreign corporation” — then the tax effects on the US shareholders are also taken into account in the case of any dividends, interest or other types of income the partnership allocates that will pass through directly to the US shareholders under US “subpart F rules.”
The IRS gave the following as an example of a case that bothers it. A and B form a partnership. A is a US corporation. B is a foreign corporation. They are both owned by the same US parent. The partnership allocates 90% of its income to B — the offshore company — and 90% of its losses to A for 15 years. Then it reverses the allocations. The income allocated to B is not “subpart F income” so it does not pass through immediately to the parent company’s US tax return.
The IRS warned that it might also attack such cases by using its general authority under section 482 of the US tax code to reallocate income in transactions between related parties.